FTSE crashes through 5000 mark

Asian markets began the falls overnight prompted by North Korean leader Kim Jong-il ordering his military on to a combat footing. Euro worries compounded the flight out of equities Photograph: Nicky Loh/Reuters

Shares in London closed at their lowest level in almost nine months today after fears of a fresh phase of the three-year global financial crisis prompted a global sell-off in equities.

Evidence that Europe's debt crisis has spread to Spain and escalating tension between North and South Korea led to a stampede out of shares and into the safe haven of bonds in Asia, Europe and North America.

With the Treasury and the Bank of England monitoring the possible impact of the euro area's deepening problems on the fragile UK recovery, more than £32bn was wiped off the value of the City's leading shares. The FTSE 100 index dropped 128.9 points to 4940.68, its lowest close since early September 2009 and a 15% drop since the middle of April.

Finance ministers and central bank governors from the G20 group of developed and developing nations will discuss the market turmoil next week amid growing concern that the debt focus of the crisis has shifted from banks to governments. Economic data showing a pick-up in activity since early 2009 and a €750bn (£640bn) support package jointly produced by Europe and the International Monetary Fund have failed to prevent a wave of selling in the past month.

Bank shares have been particularly hard hit, with investors concerned that sovereign debt defaults will leave them nursing fresh losses at a time when they are still recovering from their ill-judged investments in US sub-prime mortgages.

Documents showing that Germany is planning to broaden its ban on speculative financial trades to cover all shares added to fears in an already jittery market, which saw the Dow Jones industrial average plunge 250 points in the first two minutes of trading. It was still more than 200 points lower by lunchtime in New York despite a short-lived rally after data was published showing consumer confidence rose last month, but managed to recover somewhat to close just 22 points down, at 10,043.

Berlin stunned markets last week and drew criticism from its partners, including close ally France, by unilaterally suspending naked short selling in euro sovereign bonds, credit default swaps and the stocks of some financial companies.

"What's driving the markets so badly at the moment is concern about European banking risk, with a focus on savings banks in Spain after the restructuring of CajaSur," said Bob Parker, vice-chairman of asset management at Credit Suisse, referring to the Spanish mutual lender that had to be rescued at the weekend.

Concerns that the debt crisis affecting Greece will spread across the Mediterranean to Spain, the eurozone's fourth biggest economy, amplified an overnight fall in Asian markets prompted by North Korean leader Kim Jong-il ordering his military to be on a combat footing. The euro fell to an eight-year low against the Japanese yen and was close to the four-year low against the US dollar that it touched last week. Graham Turner, of GFC Economics, said Spain was at risk of "becoming the next domino to fall, pulling Euroland back into recession".

The rate at which banks lend to each other for three months hit a fresh 10-month high yesterday amid fears the European crisis would again cause meltdown in the banking system. The measure of such loans, known as Libor, suffered a large jump to 0.53625%, up from 0.50969% on Monday and the highest level since early July. The rate had begun rising in the early spring when anxiety about the Greek budget deficit surfaced.

Market experts blamed the high cost that the Federal Reserve was charging for emergency money for the rise in Libor. "While the use of the Fed's currency swap programme remains light, this is more a reflection of its expensiveness – it is still more than double prevailing Libor rates," analysts at Barclays Capital said.

Markit, a financial information firm, said banks were "taking a battering across Europe" and noted that South Korea was also causing some of the increased tension. Talk of war was leading to risk aversion and forced the credit default swap rates – a measure of the perceived riskiness of lending – on South Korean debt to their highest level since July 2009.

Vix, the volatility measure known as the "fear index", has also been spiking higher amid the anxiety over the euro. The index had hit a low of below 15 in April only to start climbing higher when the Greek situation erupted shortly afterwards. Yesterday it was trading above 40. That is still half the levels hit during the chaos following the collapse of Lehman Brothers.

Yusuf Heusen, a senior sales trader at IG Index, said: "While we are seeing selling across the board, it doesn't feel like a complete and utter capitulation. There is just a lack of buyers at the moment. People have been burned by previous experiences but you could see if someone led the way this market could turn around. It's a heavily fickle market."